Owners of residential real estate may have limited options concerning 1) the management, mitigation, and transference of price risk associated with ownership and, as a corollary to this limitation; 2) the utilization of their property to create capital under traditional financing arrangements. By the same token, investors may lack an efficient way to access this asset class and associated risk/return and thereby participate in single-family detached residential real estate. Outside of thinly traded futures contracts on residential real estate indices or the outright purchase of physical properties (single family detached homes), avenues into residential real estate as an asset class is nearly non-existent. In short, there is no developed derivatives product or market that bridges the needs of homeowners (e.g., risk transference specific to their ownership experience that is not tantamount to debt or equity sale) and the needs of investors (e.g., collateralized interests in property delivered in an efficient, transparent and scalable way).
Residential real estate has accounted for a larger pool of assets than the S&P® 500 for most of the past five decades. While stock or bond options and hedging instruments are widely available as a way to manage, mitigate or access risks of these traditional assets, there are almost no similarly available derivative instruments for actual homeowners (individual or institutional). As residential property is one of the most widely held assets and often makes up the largest portion of an individual's or family's total wealth, homeowners may be unfortunately compelled to gamble with a significant portion of their net worth: a most unwelcome condition of homeownership. For instance, while an owner of an individual stock issue might sell a call option (essentially selling appreciation rights for cash) and simultaneously use the proceeds to purchase a put option (locking in their value and eliminating the risk of negative price performance) so that they might enjoy the stock dividends without price risk, no such vehicle exists for homeowners. Homeowners are in desperate need of ways to “kick the gambling habit”, and enjoy the dividends of homeownership (the ability to live in the property or alternatively collect rents) without the concordant requirement to constantly speculate on future home prices. The ability to eliminate or otherwise manage risks may have saved many homeowners from the dire position they find themselves in after the collapse of the housing bubble in 2008.
At the same time, property owners often seek ways to monetize or otherwise create liquidity from the ownership of their home, perhaps in order to pay off existing debt, assist with daily expenses, or purchase investments or insurance (e.g., life insurance, long-term care insurance, home price insurance as mentioned above, and/or other insurance). In short, they may wish to transfer value otherwise tied up in the home to some other portion of their total wealth or investment/risk portfolio. They are left with only two choices: 1) sell the house, in which case they no longer enjoy the benefit of living in the property; or 2) incur certain debt and pledge their property as security for a loan.
Selling is not an option as the homeowner is seeking a way to create liquidity/monetize but retain ownership (i.e., avoid relocation and in the case of senior homeowners continue to age in place). Banks and finance companies offer products such as mortgages, direct and indirect secured loans, reverse mortgages, or revolving lines of credit as methods of using property to extend or secure credit. These are debt products and in some cases may not be available to homeowners or may be available in a limited fashion. Older age homeowners may not have sufficient current income to qualify for a traditional mortgage, and a reverse mortgage may not be sufficient based on underwriting constraints (e.g., larger house values, existing liens, location, age limits, and/or other constraints) or unavailable to younger homeowners. Broad economic and market conditions may also create obstacles to liquidity; debt-based alternatives for homeowners were severely limited during the liquidity crisis of 2008 and subsequent years and the reverse mortgage market has all but evaporated as Bank of America, Wells Fargo and Met Life have all exited the space in the last two years.
Finally, in as much as selling the property is not a welcome solution (as retention of ownership is often the very point); debt-based alternatives can be equally distasteful even when they are available. Homeowners who spent decades paying down a mortgage may not want to go sliding back into debt and the very thought of a large, lurking balance to be paid off may not be acceptable to some. Others may have a large bequest motive whereby they wish to pass on a significant property stake unencumbered by debt to the next generation. All of the existing loan products offered by banks and finance companies involve an element of certain and permanent debt incurred by the property owner until the loan is repaid. Very few existing loan products account for, or permit the use of, future appreciation of the value of the property in connection with the extension of credit. Loan products that do involve appreciation, usually tie the appreciation to the loan itself, typically in the form of a marginally reduced interest rate. These types of loans are called shared appreciation mortgages (“SAMs”) and function in many respects similar to a traditional mortgage. Funds provided under a SAM make up the principal balance, which accrues interest at the reduced rate. At the time the property is sold, in addition to the repayment of the outstanding balance owed, the appreciation realized in the property is shared in accordance with the terms of the loan. Variants of SAMs exist, whereby the entire rate of return on the principal balance is driven by the appreciation of the property, but again the litmus test for being considered a loan—the absolute right of repayment—clearly marks these as debt instruments, not an outright sale of potential and future appreciation.
U.S. residential real estate, specifically single-family detached homes, is a $19 trillion dollar market relative to the $15 trillion U.S. equity market that offers investors a unique and attractive performance profile, characterized by moderate, stable returns and low correlation to most other investable asset classes. That said, the asset class has almost zero institutional exposure due a number of issues with existing methods of both actual and synthetic investment. Actual, physical ownership comes with significant holding and management costs, a cumbersome settlement and clearing process (i.e., houses are not traded on exchanges), lack of efficient and frequent price transparency (i.e., homes need to be appraised for valuation) and generally very low liquidity relative to traditional asset classes such as stocks and bonds. Diversified, direct investment via physical ownership in residential real estate is hard to achieve.
Synthetic or indirect exposure can be achieved through futures contracts which are linked to S&P® Case-Shiller Indices® and traded on the Chicago Mercantile Exchange (CME), though these products are very thinly traded. The illiquidity created by a lack of natural buyers and sellers creates very wide spreads between “bid” and “offer” prices. Because of residential real estate's low volatility and clear, long-term cyclicality, speculators or investors (without hedging needs) tend to all have the same view at the same time. Homeowners (natural sellers) cannot use these contracts to hedge and transfer risk of changes in home prices as the limited term of the contracts (2 years) and wide spreads create insurmountable risk management costs. Perhaps most importantly, the contracts offered by the CME are futures contracts (regulated by the CFTC and the Commodity Exchange Act) with standardized asset, quantity, quality and investment terms. Put differently, they are not specific to both the property considered and the homeowner's needs (e.g., quantity or face amount and the term of the contract) and thus are not viable for efficient risk transfer. Given this absence of a large population of ready and willing homeowners as natural sellers of interests in real property via the available futures contracts, potential investors and speculators (natural buyers) have similarly not adopted this as a means of investment in residential real estate. Further, the straightforward, unstructured (i.e., there are no protections in the event home prices take time to perform in their historically stable, positive fashion) contract does not appropriately reward the investor for the illiquidity risks and market friction inherent in the CME futures. Finally, the futures contracts are not interests in real property and lack the security of being on title to a tangible, real asset. In an era of liquidity crises and bank defaults, some investors demand a “gold standard” of collateral behind their investments as opposed to the credit risks of large banks or other investors as counterparties.
The only other means of investing in residential real estate in an efficient and diversified fashion would be via a REIT structure or similar pooled investment vehicle. This is little different than the investor actually owning physical property outright, as it simply pools investors and ultimately passes on the same hurdles, costs (maintenance, property tax, property management, acquisition and disposition) and risks (vacancy and tenant risks, refinance risks for mortgage-financed transactions). Similar to direct ownership, valuation is cumbersome at best and opaque at worst as it requires actual appraisal of the real estate asset; this opacity has plagued the non-traded REIT space for years as REIT sponsors would arbitrarily set share price despite obvious changes in real estate markets. Just as in direct ownership of physical real estate, the REIT investor ultimately bears the concordant risks of maintenance, operation, tax, vacancy, etc. As such, the investor (via the REIT) must not only pay for the utility value of the property (the ability to live there), they must then also operate the property in order to recapture that value via rental streams.
The futures contracts may be an ill-fit proxy for non-customized risk transfer and wagering; shared appreciation mortgages are loan instruments that may merely capture additional value from the investor with little benefit to homeowners. Existing avenues (e.g., synthetic investment via futures contracts or actual ownership via physical purchase or REITs) may create a host of potential taxation issues for domestic and offshore investors alike. REITs and physical ownership incur property taxes (and for non-U.S. entities FIRPTA), while the futures contracts incur income or capital gains tax, all of which subtract from net investment returns.